Business owners exploring employee ownership options as part of their succession planning often need to balance multiple priorities.
Employee-owned business models are the subject of growing attention, especially as many business owners are looking at their retirement horizons. But different models for employee ownership may be better suited for different company circumstances.
Among popular employee ownership options are employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and worker cooperatives.
In this article, we’ll take a look at these three ways of transitioning a company to employee ownership, what they have in common, and how they differ.
What is an ESOP?
In short, an ESOP is a qualified retirement plan that gives employees ownership interest in the company. ESOPs are regulated by the Internal Revenue Service and Department of Labor, and are subject to some of the same regulations as other qualified retirement plans, like 401(k) plans.
In an ESOP, a company sets up an ESOP trust, which purchases all or part of the company from the business owner and holds the shares of stock on behalf of the employees. When employees terminate employment, the ESOP pays them the value of their vested shares earned through employment.
ESOPs can provide unique tax benefits both to the seller of the company and the ESOP-owned business, while also helping build wealth for low- and moderate-income workers.
ESOP vs. Employee Ownership Trust (EOT)
An employee ownership trust, also called a perpetual purpose trust, is a legal structure that allows a business to be employee-owned in perpetuity, if desired by the trustor. Employee-owners don’t buy in, they don’t accumulate ownership stakes over time, and they’re not “bought out” when they terminate employment.
An EOT is similar to an ESOP in that a trust is established to purchase the company. EOTs are not subject to the same regulatory requirements as ESOPs, and they can therefore be less complex and may involve lower costs to transition ownership and administer.
At the same time, EOTs don’t offer the same level of tax and cash advantages to the seller and the company that an ESOP can provide. In addition, because EOTs aren’t regulated by federal entities, they are instead regulated under state trust law, which may vary.
Also read: Do Employee Owned Companies Grow Faster Than Competitors?
An EOT is not a qualified retirement plan, but an EOT-owned company typically shares profits with employees as cash bonuses or 401(k) contributions.
ESOP vs. Worker Cooperative
Unlike an ESOP, a worker cooperative is directly owned and democratically governed by its employees. Like ESOPs, worker coops emphasize a shared mission, and can promote greater employee engagement that can translate to productivity and performance.
Worker cooperatives present their own tax benefits, too. Since members are owners, they are taxed once on their income, rather than being taxed separately at the corporate and individual levels. Worker cooperatives are also subject to far less regulation than ESOPs, and cost less to establish and administer.
On the downside, the equal equity stakes in a coop can actually make larger investment contributions less attractive for investors. It’s also important to consider that democratic governance can lead to slow decision-making.
Both the pros and cons of worker coops make them a possible employee ownership alternative for companies that may not be good candidates for an ESOP.
Side-by-side Comparison of Employee Ownership Options
|Worker Cooperative||Employee Ownership Trust (EOT)||Employee Stock Ownership Plan (ESOP)|
|Can include taxable bonuses or qualified profit-sharing plan||Yes, an ESOP is a qualified retirement plan|
|Does it provide a succession plan for owners?||Yes||Yes||Yes|
|Do employees purchase their stake in the business?||Yes, but equity buy-in can be relatively low-cost and set relative to workers’ earnings||No cost to employees||No cost to employees|
|Do employee-owners have to have voting rights?||Yes, coops are democratically governed||No, but they can if the EOT is designed that way||No, but they can if the ESOP is designed that way|
|Designed to preserve ownership?||Yes||Yes, as long as the trustor desires||Not necessarily; potentially beneficial acquisition offers need to be considered, due to fiduciary rules|
|How much of the company is employee-owned?||100%||A controlling interest up to 100%||Any portion up to 100%|
|What is the ideal company size?||Any number of employees||Any number of employees||10-15 employees or more*, with optimal thresholds for revenue determined by initial valuation|
|What does it cost to establish and administer?||Least||Mid-range||Greatest (but tax savings and cash flow advantages can offset costs)|
|Does it offer special tax benefits?||Some: Profits shared are tax-deductible to the business; in some cases, seller may defer capital gains on sale for life||No special tax advantages||
Most: A 100% ESOP-owned S corp pays no federal income tax; seller may defer capital gains on sale for life
|Heavily regulated?||No||Covered by state trust laws||Yes, by the IRS and Department of Labor|
|Can share value appreciate?||No||No||Yes|
|How is it financed?||Seller, workers, outside investors and lenders can all be involved in financing||Can be seller financed or lender financed||Can be seller financed or lender financed|
*Some experts use 20 or more employees as a cutoff. In truth, there aren’t hard and fast rules and small, growing companies can successfully transition to an ESOP with the right guidance and discipline. Wondering about your company? Request a no-cost feasibility analysis.
Choosing the Right Employee Ownership Model for Your Business
Choosing the right path to employee ownership can be tough for any business owner who needs liquidity and wants what’s best for the company and employees moving forward. It may be helpful to consider that employee ownership models of all types can help support employment in communities that need jobs — and employee-ownership culture promotes productivity and employee engagement, and attracts and retains quality employees.
Which employee-ownership model is right for your organization, and how can you best move your exit strategy forward? Our interactive quiz, Is an ESOP Right for You?, takes out the guesswork and walks you through the critical questions about whether your company’s a good fit for an ESOP. Just click the link below to take the quiz.